A Radical Proposal for Improving Capitalism

By

Eric A. Posner and E. Glen Weyl

June 15, 2018 1:14 pm ET

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Institutional investors such as BlackRock and Vanguard must be scratching their heads. Long praised for offering customers low-cost, passively managed (index) mutual funds, they are being buffeted by criticism. Some call them a cartel of capital markets: Because institutional investors own the largest stakes of all big firms in virtually every market, they have an incentive to reduce competition among firms, raising prices for consumers and lowering wages to workers. Two economic studies show evidence of such negative effects for airlines and banking.

The other, apparently contradictory, criticism is that institutional investors neglect their duty to govern the firms they own. As more people put their money in mutual funds rather than direct stock investments, fewer shareholders are likely to pay attention to the firms they own, and vote or exercise influence. Because institutional investors have touted passive management for saving costs, they are in a poor position to govern firms on clients’ behalf. This means big corporations will be rudderless or, more likely, controlled by their managers instead of their owners.

A simple but surprising reform that we propose could address both problems: Limit large institutional investors to owning shares in just one firm within any industry. For example, a large institutional investor could own a stake in
United Continental Holdings
or
American Airlines Group
or any other airline, but couldn’t simultaneously hold stakes in United and American. This idea might seem radical, but it preserves and advances the logic of capitalism.

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In economic and legal theory, corporations are merely pieces of property collectively owned by their shareholders. And at least since Aristotle, people have understood that a person who owns, say, a house will be most likely to take care of it as long as she lives in it and can sell it. If not, she will let the house fall into disrepair, like Soviet-era apartment blocks owned by the state and managed by bureaucrats. Thus, the social contract of private property is that while the owner benefits from the property exclusively, she is also supposed to take responsibility for managing the asset she profits from.

With the invention of corporations, ownership was separated from control and responsibility. To raise capital, corporations need a large pool of shareholders. But because each shareholder benefits only to a tiny degree from the corporation’s profits, none has an incentive to monitor the corporation and ensure it is operated properly.

Granting a CEO some equity in the firm might partly alleviate this problem. However, a CEO owns only a small stake and can abuse his position for personal reasons. Some scholars have even argued that if this is how a corporation works, shareholders aren’t needed. The corporation could be funded by taxpayers, with profits paid to the Treasury. Capitalism with passive shareholders isn’t much different from socialism, except that the CEO is paid a lot more than a bureaucrat is, and given a share of profits when things go well.

It was once thought that institutional investors could help alleviate this problem by serving as agents of passive shareholders. Institutional investors can afford to hire staff to monitor, advise, and, if necessary, discipline corporate managers. And institutional investors do play this role to some degree—by owning actively managed funds, or feeling obliged to guard the interests of clients of passive funds.

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Yet even as institutional investors have grown, they have presided over a growing oligopoly within markets and, if studies are believed, higher prices for consumers. Average company markups (the most common measure of monopoly power) have increased, according to a recent analysis, more than threefold, to nearly 70%, during the period of growth of institutional investors from the 1970s to today. The most plausible explanation is that CEOs know that their bosses, the institutional investors, gain when competition is kept within bounds, and so don’t incur the costs and take the risks to compete for market share. Evidence also suggests that compensation packages give CEOs worse incentives to compete when institutional investors have relatively large stakes.

Our reform would spur institutional investors to induce their subordinate firms to compete with one another. If an institutional investor owns only one airline, it gains when that airline expands its market share at the expense of others through tough competition. Second, because institutional investors would own larger stakes in each firm, they would have stronger incentives to actively monitor CEOs.

Our critics argue our reform would make it more difficult for investors to obtain a fully diversified portfolio. However, because the stock values of firms within industries tend to be correlated, the real value of diversification comes from owning stock across industries. People who want more diversification can buy funds from multiple institutions.

The legitimacy of capitalism depends on companies following through on the promise of better jobs and lower prices. The failure of capitalism to deliver in recent decades helps explain the emergence of populist leaders around the world. Our reform would enhance capital markets and help preserve capitalism from its own worst enemy—the capitalists.

Eric A. Posner is the Kirkland and Ellis Distinguished Service Professor at the University of Chicago Law School. E. Glen Weyl is principal researcher at Microsoft and visiting senior research scholar in economics and law at Yale University. Posner and Weyl are the authors of Radical Markets: Uprooting Capitalism and Democracy for a Just Society.

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